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The biggest sleeper in the debate over financial service regulatory reform is how brokers and investment advisers will be regulated.

The lion's share of attention has been given to hot-button issues like the Obama administration's proposed new financial consumer protection agency and ending government bailouts of large financial companies.

That's because most investors end up investing their money the way their adviser recommends. If they go to an investment adviser, chances are good they will end up investing in mutual funds. If they go to a broker, they could be put in stocks, mutual funds or wrap accounts. And if they go to an insurance agent, they are more likely to end up invested in annuities.

Investors Spend Little Time Researching Investments

Moreover, the fees and commissions they end up paying -- and what their adviser tells them about potential conflicts of interest before they invest -- matter. Most investors probably are not inclined to spend time researching their investments. That's what they pay a financial adviser to do, after all.

And the fees that are charged on their investments, whether they are up-front commissions or ongoing fees, add up over the long-term. They also have a significant impact on the retirement nest egg people end up with after saving and investing during their working years.

But a little-noticed debate that has been taking place within the financial advisory community for years is not one that is easy for most retail investors to follow. The chief issue is whether financial advisers should come under fiduciary standards, which means they are supposed to act in the best interest of their clients.

Investment advisers, regulated under the Investment Advisers Act of 1940, are held to that standard. And most experts in the financial services industry agree that the fiduciary standard is higher than the regulatory standards brokers come under.
Investment Advisers Face More Regulation Than Brokers

Brokers are regulated under a different standard. Investment advisers are overseen directly by the Securities and Exchange Commission and state securities regulators, which of course are government regulatory bodies. Brokers, meantime, are directly supervised by the Financial Industry Regulatory Authority, a self-regulatory organization of the brokerage industry.

Brokers are required to make recommendations that are suitable for their clients. But that gives brokers leeway to recommend proprietary products that their firm pushes them to sell. It also gives them the ability to suggest products that may pay them the best commission or other fees, even though the investment may not end up being the most economical or best-performing for the client.

Investment advisers are required to make advance disclosures of fees and potential conflicts of interest, while disclosures brokers are required to make may not be as comprehensive. And, in the event of a legal dispute, brokerage firms disavow fiduciary liability, which makes it more difficult for plaintiffs to make claims and win damages.

When securities laws were first enacted, brokers primarily executed trades. But in recent years, brokers have moved more toward providing advice as more middle-income people who are investing for retirement seek advice. In the end, this has made them function more like investment advisers.

Regulators Frowned on Brokers 'Churning' Accounts

To move brokers away from incentives to "churn" customers' accounts by trading investments primarily to make commissions, the SEC at one point ruled that they would be exempt from having to register and be regulated as investment advisers. Favored by the brokerage industry, the exemption would have spared them the extra liability that investment advisers carry. It would also have allowed them to charge fees based on assets. What's more, the rule would have let brokers to continue selling investments owned by their brokerage firms.

It is more difficult under investment adviser regulations to make such "proprietary trades" to investors. That's because it can be a conflict of interest if firms push their own investments on customers when the investments are not in the customer's best interest.

The U.S. Court of Appeals for the District of Columbia Circuit overturned the SEC rule after the Financial Planning Association filed a lawsuit against it. Since then, a 2008 study conducted by the RAND Corp. for the SEC found that investors are confused by the different regulatory schemes for brokers and investment advisers. That was not a surprise.

What was more of a surprise was the finding that, even when researchers explained the legal differences, most investors did not believe that the legal and regulatory differences had a significant impact on them.
An Early Regulation Proposal Was Scuttled

Early on in the financial reform debate, members of the SEC, including Chairman Mary Schapiro, FINRA Chief Executive Officer Richard Ketchum, as well as the Securities Industry and Financial Markets Association, which represents the brokerage industry, embraced the idea of having all advisers held to fiduciary standards. The Wall Street Reform and Consumer Protection Act approved by the House of Representatives last December includes provisions that would bring all financial advisers who provide personal advice to retail investors under fiduciary standards.

But insurance agents and some brokerage groups were able to scuttle an early proposal by Senate Banking Committee Chairman Christopher Dodd (D-Conn.) that would have fully required all brokers giving advice to register and be regulated under traditional fiduciary standards. Instead, a bill approved March 22 by the committee would just require the SEC to study the issue and issue new regulations governing financial advisers.

While insurance agent groups say a new study is needed to come up with recommendations to harmonize regulation of financial advisers, many others in the industry say no more study is needed. But, to the extent that the SEC does end up examining the issue again, the cost that customers end up paying to invest through either brokers or investment advisory firms is likely to come up.

Brokers argue that their traditional method of selling on commission allows more middle-income people to get investment advice. How's that? They argue that these investors are less able to pay high fees for financial plans or meet relatively high investment minimums required by investment advisers.

Account Minimums Less Likely With Brokers

"One of the first things I ask investment advisers I am in contact with is do they have an account minimum," says David Bellaire, general counsel and director of government affairs for the Financial Services Institute in Atlanta, which represents dually-registered broker-dealers and investment advisory firms. "Invariably I'm told, yes they do," he says. "It's clear to me that advisers determine they need to hit that minimum before it makes sense for them to work with that client."

Brokers are less likely to require account minimums, or, if they do, the minimums are likely to be less, says Bellaire, whose group supports the Senate language requiring the study. "We know that smaller investors would not be able to get the advice and support they need if we flip the switch and everyone has to be an adviser under the Advisers Act."

But cost is an issue that the SEC may well consider studying, albeit it will be difficult to do. "There's no way to quantify precisely the net costs and benefits of fiduciary duty," says Mercer Bullard, an associate law professor at the University of Mississippi School of Law who founded Fund Democracy, a mutual fund shareholder advocacy organization.

But, Bullard, who favors fiduciary standards, also disputes claims by brokers that costs would rise if all advisers were required to be fiduciaries. "For them to say that it will raise cost is to completely ignore any benefit to investors from a fiduciary duty," he said.
Will the SEC Weaken Standards to Accommodate Brokers?

Such costs can include the costs investors may bear if they are sold higher-cost, lower-performing investments, he said.

Moreover, to further complicate the debate, investment advisory groups and state regulators fear the SEC itself may weaken fiduciary standards to accommodate brokers. Indeed, Luis Aguilar, who serves on the five-member commission and is a proponent of the traditional fiduciary standard for all advisers, expresses that worry. "I am concerned that either Congress or [the SEC] will do something to weaken the standard," he says. "As a commissioner I have only one vote."

Ms. Schapiro formerly served as CEO of FINRA, and SEC member Elisse Walter headed regulation at FINRA before joining the SEC, which causes investment adviser groups to worry they could favor broker regulations in coming up with new rules for advisers.

Brokers also make the argument that the SEC is only able to audit 9% of SEC-regulated investment advisory firms, while FINRA is able to examine a majority of the brokerage firms it oversees. Yet both FINRA and the SEC missed the massive Ponzi scheme taking place at Bernard L. Madoff Investment Securities LLC for years. That failure occurred both during the time that Madoff operated as a broker-dealer, as well as after he was forced to register as an investment adviser with the SEC in 2006.

SEC Should Look at Results Brokers and Advisers Provide

Investment adviser groups strongly oppose being brought under FINRA, which they argue has a culture more geared toward the brokerage industry than the investment advisory industry. But even if FINRA were to become the regulator of investment advisers at some point, it would likely move toward more of a fiduciary standard than brokers would want.

No matter which version of legislation is enacted, the SEC is almost certainly going to have to revisit this issue. In addition to looking at costs for investors, the agency should consider looking at what results investors with both types of advisers are actually getting. Do investment advisory clients come out ahead over both the short- and long-term compared to brokerage customers?

Further, the SEC should consider requiring both advisers and brokers to make disclosures -- before securities are purchased -- of whether a customer would pay more buying a security on commission or paying fees based on assets. In addition to getting better cost pre-sale disclosures, customers would have to give some consideration to whether they plan to hold investments for the short term or the long haul.